Gaining Leverage While Lowering Risk in Construction Lending

Leverage typically comes in two forms – financial and power. When a borrower requests a construction loan, they need the financial leverage the loan provides so they can construct (or renovate) buildings to produce a profitable investment. However, once a construction loan is approved, they gain a different type of leverage – one of power that grows as each draw is disbursed. Why? Because no lender wants their borrower to default, forcing them to take back an unfinished property/project.

With today’s economic uncertainty, which includes increased material prices, supply chain delays, and construction labor shortages, the risks continue to grow for all parties involved in a construction project. Although the borrower is ultimately meant to foot the costs of a project, the lender actually takes on the majority of the risks, as it is their funding that supports the construction. Construction loans have higher interest rates because they come with a lot of risks for the lenders. Unfortunately, most every construction risk equates to substantially increased costs: schedule delays translate into extended general conditions; material shortages mean higher prices; competition for a limited labor force means higher wages to attract and keep jobs staffed.

What happens when construction costs increase?

The increases typically fall on the borrower, as the lender has capped the amount of their loan. However, when costs surpass the borrower’s budget, the borrower may push back on the lender to increase their loan amount. At that point, the lender is put in a situation where the borrower has more leverage: either approve a larger loan amount or risk that the borrower, unwilling to pay more, will default. A default mid-construction often results in the property being worth less than the land alone and/or the loan amount. Then come the headaches of appointing a receiver and foreclosing on the property… or at least that is what was typically done.

Today, lenders have options to gain the upper hand with difficult borrowers, which ultimately increases their leverage. They can require that project completion insurance be purchased prior to closing on a loan, which assigns the lender as the beneficiary in the event their borrower defaults. It is typically cheaper than most surety bonds and is both quick to fund and easy to call.

So, how does this provide the lender leverage?

The lender now has an alternative to customary foreclosure proceedings that will assure the project gets completed regardless of a borrower’s default. The lender no longer needs to fear default; in fact, the project completion insurance provides the lender with leverage to encourage their borrowers to comply with loan covenants, as they can now call a borrower’s bluff.

Project completion insurance is a new type of insurance at competitive pricing because it is added on to the comprehensive construction risk management services required for the loan, which includes project documentation and contractor due diligence before loan closure, construction monitoring and funds control after loan closure, and professional project management services in the event of general contractor default. Most risky loans already require one or more of these due diligence and risk management services. Having project completion insurance simply completes a lender’s risk management profile to include financial protection in the event of borrower’s default.

What about today’s construction market?

Today’s climate necessitates that construction lenders place more and more scrutiny on their borrowers due to the uncertainty involved in a construction project. However, rising interest rates and inflation have had a cooling effect on the number of construction loans being requested. Construction lenders may now consider borrowers whom they previously may have rejected, as long as enough risk management and credit enhancement measures are taken. These once over-looked borrowers may not be as financially leveraged as lenders are used to working with during less risky climates. Deals lenders might now consider may originate from less experienced developers, or even from ultra-risky owner/builders. These borrowers require more scrutiny and caution, and credit enhancements can help to ensure the project can and will be funded through the project’s completion.

The appeal of credit enhancements is that they benefit both the borrower and the lender. The borrower can use credit enhancements to get approved for a loan and to negotiate better terms. On the other hand, credit enhancements allow lenders to make a deal they may not have made without them.

Which credit enhancements should be considered?

Credit enhancements can include surety/P&P bonds, letters of credit, the inclusion of additional guarantors, restricted cash, as well as project completion insurance. However, the problem with many credit enhancements is that they can be expensive; the funding may be difficult to acquire; and/or they may result in litigation. The table below offers a very high-level overview of major advantages/disadvantages, and shows that with the exception of project completion insurance, credit enhancers often have more disadvantages to the borrower and lender than advantages.

CREDIT ENHANCEMENTS	ADVANTAGES	DISADVANTAGES
Project Completion Insurance	Less costly than bonds (40-60 bps) Lender is beneficiary in the event of borrower default Quick funding / easy to call Proactive Contract is for the duration of the project (no renewals) Enables more leverage	Lender pays 10% copay of overbudget costs at each draw after original loan amount is depleted Copay may or may not be recouped upon sale of the project Borrower is not covered
Surety / P&P Bond	Good for public projects Borrower is beneficiary in the event of contractor default Most commonly required credit enhancement measure	Expensive (50-300 bps) Slow to respond Tough to perfect claims / difficult to collect Can result in expensive litigation for owner Not an option for owner/builders Renewal fees in the event of delays Does not fund in the event of borrower default
Letters of Credit	Provide lenders access to cash with fewer obstacles to obtain Quick to administer	Expensive Requires borrower to be well-capitalized Handcuff borrower’s operation by potentially restricting working capital Has an expiration date – delays would require a renewal plus any fees
Additional Guarantors	Improve a project’s credit profile Guarantors sign completion guarantees Often improve borrower interest rate	Difficult to obtain guarantors Potentially costly to borrower or developer; may have to give up equity stake to secure guarantors Lenders often need to file an after-the-fact suit for damages as a primary recourse against these tools
Restricted Cash	Money is set aside for loan Funds accrue interest Reimbursed if project is completed on time and on schedule	Ties up borrower’s working capital Not an additional source of capital Deal killer for borrower/builders since cash is king

Are credit enhancement measures worth the cost to the borrower (and indirectly, to the lender)?

Absolutely. It’s the difference between making a deal or not making a deal. But some options work better than others for both the borrower and the lender. For borrowers, the following points are important:

Which is the least costly?
Which can be procured easily?
Which is the easiest to navigate and call upon?
Which lowers the risks of substantial delays (and by default, additional costs)?
Is the borrower also the developer? Developers don’t qualify for most bonds and may be unwilling to tie up their capital as some options require.

However, the borrower’s concerns are only half of the equation. Much like instructions given for use of an airplane’s oxygen mask, lenders need to take care of themselves first and then consider:

Is litigation likely if it’s necessary to call upon the credit enhancement?
How quickly will the project be funded?
Who does the credit enhancement benefit? In cases like bonds, the main beneficiary is the borrower and is only called in the event of contractor failure. A bond offers no protection in the event of a borrower’s default.
Which provides the lender with the most leverage?

Choosing a credit enhancement is not an either/or scenario. The utilization of one or more credit enhancements is up to each lending institution so that they can get comfortable with the construction loan and borrower. Project completion insurance, for example, is relatively new to lenders. Despite being the most beneficial to lenders, it may take time before it becomes a standard selection from among the available credit enhancements. Project completion insurance can also benefit lenders and borrowers by allowing lenders to offer construction loans to owner/builders who would otherwise not be qualify for a loan due to their inability to be bonded. One of the greatest advantages of project completion insurance is it gives the lender added leverage when necessary to persuade a borrower to comply with loan covenants, and increases overall confidence that, even if the borrower doesn’t comply, the project will still get completed.

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Article originally published on GlobeSt.com.